The Australian Taxation Office (ATO) has taken a significant step in shaping its approach to transfer pricing compliance with the recent release of Draft Practical Compliance Guideline PCG 2025/D2, addressing the tax risks associated with the amount of inbound, cross-border related party financing arrangements.
Released in response to legislative reforms under the Treasury Laws Amendment (Making Multinationals Pay Their Fair Share — Integrity and Transparency) Act 2024, the draft PCG outlines how the ATO intends to assess whether the quantum of related party debt aligns with the arm’s length principle under Subdivision 815-B of the Income Tax Assessment Act 1997 (ITAA 1997).
The PCG is both timely and ambitious. It seeks to bring clarity and administrative guidance to a technically complex and commercially sensitive area: how much debt a taxpayer can justify as arm’s length when borrowing from a related offshore party.
While the draft PCG reflects the key principles from the OECD Transfer Pricing Guidelines and aims to reduce uncertainty, it also introduces heightened expectations on taxpayers with respect to documentation, commercial justifications, and alignment with third-party benchmarks.
In this article, we share our view on the draft PCG’s framework, explore its interaction with Australia’s new thin capitalisation rules, and identify the practical challenges that taxpayers, especially inbound investors, may face in adapting to the ATO’s evolving expectations in this area.
Legislative and Policy Context: A Shift from Rate to Quantum
Historically, Australia’s transfer pricing rules allowed certain taxpayers to treat the actual amount of debt as a given, focusing any transfer pricing analysis on whether the interest rate was arm’s length. This approach was reinforced by section 815-140 of the ITAA 1997, which modified the application of Subdivision 815-B in the context of debt deductions.
That framework has now changed. The 2024 reforms repealed the safe harbour created by section 815-140 for general class investors and financial entities applying the third party debt test. As a result, affected entities must apply the full scope of arm’s length principles to both the rate and the amount of related party financing. In other words, taxpayers must now demonstrate that the debt amount itself is consistent with what would have arisen had the parties been independent and dealing at arm’s length.
This change is aligned with the OECD’s current direction of travel, especially the increased emphasis on the “options realistically available” to taxpayers, and is underpinned by the Government’s broader objective of ensuring multinational groups do not use excessive leverage to erode the Australian tax base.
The Structure of PCG 2025/D2: Four Zones of Compliance Risk
PCG 2025/D2 introduces a four-zone risk framework to help taxpayers self-assess the ATO’s likely compliance posture based on the nature and characteristics of their inbound financing arrangements:
- White Zone: Arrangements that have already been reviewed or concluded via an agreed outcome (e.g. via APA or litigation outcome).
- Green Zone: Low-risk arrangements, including those aligning with the ATO’s illustrative examples or where leverage and interest coverage ratios are better than those of the taxpayer’s global group or independent comparables.
- Blue Zone: Neutral or unassessed territory – arrangements that don’t fit the high or low-risk categories but may still be actively monitored and reviewed by the ATO.
- Red Zone: High-risk arrangements per the PCG examples, including those involving guarantees, excess cash reserves, or on-lending at below-market returns.
This framework builds on previous PCGs such as PCG 2017/4 (on the pricing of related party loans), but PCG 2025/D2 breaks new ground by turning its attention to the quantum of debt – a more subjective and commercially complex matter.
While the zone-based approach brings a welcome degree of predictability to compliance triage by the ATO, taxpayers must appreciate that being in the red zone does not necessarily mean they have a transfer pricing problem – it means the ATO may look more closely and expect robust substantiation of the debt amount.
Twelve Factors Driving the Arm’s Length Debt Assessment
At the heart of draft PCG 2025/D2 is a detailed discussion of the twelve key factors the ATO will consider when assessing whether the amount of related party debt is consistent with arm’s length conditions. These include:
- Funding Requirements: Whether there is a genuine business need for the funds.
- Group Policies and Practices: Alignment with group treasury protocols and leverage policies.
- Return to Shareholders: Whether the investment funded by the debt delivers expected returns.
- Cost of Funds: How the chosen financing affects overall cost of capital.
- Covenants: How financial covenants impact borrowing capacity.
- Explicit Guarantees: Whether the amount of debt reflects the borrower’s standalone credit profile or the strength of a related party guarantee.
- Security: The availability and quality of collateral.
- Serviceability: The borrower’s ability to meet both principal and interest obligations.
- Leverage: Ratios compared with peers and group benchmarks.
- Availability of Internally Generated Funds: Cash on hand or retained earnings.
- Availability of Equity Capital: Whether equity could have been used instead.
- Options Realistically Available: Whether the arrangement chosen is the most commercially rational option among alternatives.
This analytical framework mirrors the type of inquiry that a prudent lender, or a cautious board, might undertake before approving a financing decision. That is conceptually sound. But applying such a framework in a related party context, where decisions may be made centrally or informally, introduces new compliance expectations.
Documentation Expectations: Raising the Bar
Perhaps the most practical implication of PCG 2025/D2 is its expanded documentation requirement. The ATO expects taxpayers to retain a range of evidence, including:
- Internal decision-making papers and board minutes.
- Calculations or workings showing evaluation of returns to shareholders.
- Debt sizing models and financial forecasts.
- Treasury policies and capital management frameworks.
- Evidence of market testing or third-party comparables.
- Analysis of alternative options that were considered but rejected.
- Documentation of covenants, guarantees, and other contractual terms.
These expectations go beyond traditional transfer pricing reports and will require coordination between tax, treasury, finance, and legal teams.
For large multinationals with mature governance processes, this may be achievable. But for mid-market inbound investors, these standards may be difficult to meet, particularly where funding decisions are driven by group-wide strategies rather than localised debt planning.
Risk Examples: Where the ATO Will Likely Focus
The guideline provides five illustrative examples, (two low-risk and three high-risk), which help to crystallise the ATO’s thinking.
Low-Risk Examples:
- Where an entity applies the third party debt test and related party interest deductions are excluded from the thin cap earnings limit.
- Where the taxpayer’s leverage and interest coverage ratios are equal to or better than those of its global group and a set of independent comparables.
High-Risk Examples:
- Use of related party debt despite holding substantial cash reserves, where the debt generates higher deductions than the return on the cash.
- Borrowing beyond commercial levels due to reliance on a related party guarantee.
- On-lending borrowed funds to another group member at a rate below the cost of borrowing, resulting in a net tax deduction in Australia.
While these examples are useful, their treatment of commercial features such as cash holdings and guarantees could lead to unintended consequences. For instance, holding cash for working capital, acquisitions, or regulatory purposes is often prudent rather than aggressive. Likewise, guarantees are a standard tool in group financing, demanded often by financiers. The PCG would benefit from recognising that these features are not inherently high-risk unless combined with other aggressive features.
Observations and Concerns: Striking the Right Balance
At Andersen, we support the ATO’s commitment to transparency and principled compliance. However, several concerns arise from the draft PCG that warrant further attention as the consultation process progresses:
1. Proportionality and Practicality.
The expectations around documentation and analysis are more suited to multinational enterprises with sophisticated treasury operations. Mid-tier and smaller inbound groups may struggle to meet the evidentiary standards, even when their debt levels are commercially justifiable.
2. Commercial Flexibility.
Global groups often use cash pooling, centralised treasury functions, and internal guarantees as part of legitimate capital management processes. The ATO’s treatment of these features as risk indicators—without distinguishing between substance and form — may discourage efficient global capital deployment.
3. Uncertainty Around ‘Options Realistically Available’.
While this concept is grounded in OECD guidance, the “options realistically available” test in the PCG introduces subjectivity. It may lead to disagreements over hypothetical counterfactuals that are difficult to evidence, even with robust documentation.
4. Interaction with Thin Capitalisation.
PCG 2025/D2 sits alongside, not within, the thin capitalisation rules. However, the practical interplay between Subdivision 815-B and Division 820 may create confusion for Taxpayers. The ATO should include commentary to clarify how transfer pricing adjustments interact with thin capitalisation outcomes, particularly when a third-party debt test is applied.
Conclusion: A Thoughtful Guideline That Needs Practical Refinement
PCG 2025/D2 is a thoughtful and necessary step in guiding taxpayers through the new post-reform transfer pricing landscape. It recognises that arm’s length conditions apply not only to pricing, but to the amount of financing; a position well supported by the legislative reforms and OECD guidance.
However, the PCG’s practical application will need to balance policy integrity with commercial reality. Taxpayers need clearer thresholds, better accommodation of group financing practices, and scalable documentation requirements to enable all Taxpayers to navigate the regime confidently and efficiently.
We encourage affected taxpayers to participate in the consultation process prior to the 30 June 2025 cut off. A collaborative approach will help ensure that the final guideline fosters certainty, fairness, and efficient compliance for both large and mid-sized inbound investors.
For further insights or to discuss how PCG 2025/D2 may affect your financing arrangements, please contact your Andersen adviser.
